Gap Insurance: 7 Hidden Risks To Know About

In the second it takes you to lift the pen off the purchase agreement, your new car becomes used, and you've probably lost 11 percent of its purchase price. On the first anniversary of that split second, you're likely to be down a total of 19 percent and a year after that 29 percent.

Those are average losses according to multiple surveys, and, if you buy a model that's unpopular, expensive or exotic, you could end up losing much more.

Everyone knows that new cars lose value ("depreciate") quickly, and that's fine: It's the price you have to pay for the privilege of owning your own vehicle, the pleasure of that new-car smell and the prestige of driving around in a status symbol.

What gap?

But suppose you buy your new or nearly new vehicle with a low- or zero-down payment auto loan -- or lease it. Chances are you're going to owe more on that loan or lease than the car's worth for years to come. And, if your pride and joy is totaled in a wreck or stolen and not recovered, even comprehensive insurance is going to pay you only the book value (what it takes to buy a similarly used car) rather than the current balance on your loan or lease.

The cash difference between what your insurer pays out and what your lender/leasing company demands could be quite a gap. And gap insurance is supposed to fill it.

Keep reading to discover more hidden insurance risks for new car owners and leased vehicle drivers, and how gap insurance sometimes doesn't fill the whole gap.

1. When there's too big a gap for you

Not everyone has to worry about that gap. For example, if you have the sort of financial resources that allow you to write a check for thousands of dollars without grimacing, you may prefer to live with the risk of one day having to do so.

But if the thought of writing such a check fills you with horror, then you should probably consider protecting yourself, if only for peace of mind. Remember: it doesn't matter how perfect your own driving record is, there is an endless supply of idiots out there who seem bent on totaling your car, sometimes when you're not in it.

Loretta L. Worters, vice president of communications for the Insurance Information Institute, suggests, "It's a good idea to consider buying gap insurance (and may even be required) for your new car or truck purchase if you:

Made less than a 20 percent down payment.

Financed for 60 months or longer.

Leased the vehicle.

Purchased a vehicle that depreciates faster than the average.

Rolled over negative equity from an old car loan into the new loan.

Drive more than the average 15,000 miles annually."

Those are the circumstances in which you're most likely to face the scariest gap, and we'll return to some of them later. Tick one on the above list, and you have grounds to be worried. Tick more and you could start to lose sleep. Luckily, you can obtain gap insurance coverage at any time during or after a purchase.

2. When you lease your vehicle

This sort of coverage is generally obligatory for leased vehicles. Indeed, some dealerships buy master policies to cover all their leases, and you pay for a gap waiver, the cost of which is often rolled up within your monthly payment.

However, that system isn't universal, and you should ask your dealer whether it has a master policy. If it does, ask for a copy so you know your coverage and what you need to do (or not do) to remain in compliance with it. If it doesn't, ask whether you can source your own gap policy. It may be much cheaper than the one the dealer's offering.

3. When you get your policy from your dealership

If you're even remotely likely to benefit from it, the salesperson from whom you're buying your vehicle will likely pitch gap insurance. You might be offered the chance to roll up payments into your overall loan, which allows you to spread the pain, but that also means you're going to have higher monthly payments and will pay interest.

Worters explains why you should think twice about such an offer. "One of the biggest mistakes consumers make when purchasing gap insurance is to buy it at the dealership. Many people think they have no other choice, that they have to buy it from the dealer. But most car insurers offer it and at a lot less. On most auto insurance policies, including gap insurance with collision and comprehensive coverage adds only about $20-$30 a year to the annual premium. And the cost typically goes down along with the cost of collision and comprehensive as the vehicle ages. Dealerships charge about $600."

Clearly, some dealers and salespeople are better than others, but that sort of price gouging is commonplace. So get quotes for this coverage from your existing insurer and others before you sign your purchase agreement. If the dealer can beat those, fine. If not, go with the deal that provides the protection you need at the lowest price.

4. When you're not "normal"

Of course, you're "normal," no matter what your mother tells you. But you can hit problems with your gap coverage when your use of your car or truck isn't.

Your lease may impose caps on the number of miles you can drive each year, and, if you exceed those, any penalties imposed on you won't be covered by your gap policy.

Similarly, the book value of your car should be reduced if your annual mileage is significantly higher than average (currently 13,476, according to the Federal Highway Administration), and that would see your payout under your comprehensive policy made smaller. Your gap coverage won't cover that shortfall.

The International Risk Management Institute (IRMI) says that you could also lose out if you've used your vehicle for towing, if it's had prior damage, if the wear and tear it's suffered has been excessive or if it's been in prolonged storage. All of these could affect the pre-wreck value of your car, and your gap policy likely excludes them.

5. When you pimp your ride

In this case, "pimping" doesn't just mean an extreme makeover of your vehicle. It includes any modifications made to it since it left the factory -- including equipment and other upgrades performed by the dealer prior to your taking delivery.

The cost of these is almost always deducted from your gap payout, as are other non-standard expenses, such as credit life insurance and extended warranties.

6. When you don't read your policy

When Worters says, "I'd advise anyone buying a new car to read the policies carefully," she's not kidding. Those that are issued directly by mainstream insurance companies are closely regulated, and need to be fair and transparent. But in many states those that are issued by lenders, often through dealerships, are subject to little or no regulation. In other words, you're on your own.

According to the IRMI, some may prevent you from taking the insurer to court, instead mandating arbitration processes that are binding. Others might specify that the policy is subject to the laws of a different state from the one where you live and buy your cars. And that could severely limit your options if you get into a dispute.

7. When a cosigner is involved

William J. McCormick sells cars in a big dealership in West Virginia, and he tells a very sad story about the dangers of co-signing an auto loan without gap coverage. About four years ago, two longstanding friends and colleagues came onto his lot looking for $35,000-worth of prestigious new car. The younger woman, who was in her 30s, was the buyer, but her average credit meant she could only acquire such an expensive vehicle with a tiny down payment if her dear friend, who was in her 50s, co-signed the agreement. A gap policy was offered, but declined.

It was only weeks later that the car was totaled. You can imagine what happened next: The finance company went after the older, richer woman. She lost many thousands, a friendship that should have lasted a lifetime dissolved amid bitter acrimony and the whole sorry mess ended up in court.

Bridge over troubled waters

Whether or not a cosigner is involved, gap insurance is a vital protection for many. Imagine how the younger woman in that story would have coped had she had to face the finance company alone.

Gap coverage may sometimes fail to completely bridge the chasm between what you get from your collision or comprehensive policy and what you owe your lender or lessor. But it usually gets you close enough to comfortably step over the remaining space. If your car were totaled, how would you cope without it?